STRENGTHS

Strategically located at the centre of trade routes between Asia and the Middle East

Indian, Chinese, and Japanese interests

Strong growth of tourism

WEAKNESSES

Agricultural production vulnerable to climate disasters

Low levels of capital public spending due to debt servicing burden

Vulnerability linked to reliance on short-term external financing

Lack of infrastructure

Ethnic tensions between Sinhalese and Tamils

RISK ASSESSMENT

A political crisis that could undermine the recovery

In 2019, the strength of the Sri Lankan economy will be constrained by the political crisis that has been unfolding since October 2018. Mainly supported by activity in the services sector, growth is also likely to be affected by continued political uncertainty ahead of the general elections scheduled for mid-2020, with tourism (11.6% of GDP) likely to be the hardest hit. The construction sector could also be hurt by the postponement of infrastructure projects, with Japan and the United States announcing in November 2018 that they were suspending financing (USD 1.4 billion and USD 500 million respectively) for infrastructure projects until the crisis is resolved. Manufacturing, notably textiles and clothing, should continue to benefit from the Generalised System of Preferences with the EU, which eliminates tariffs on almost 1,200 Sri Lankan products, including various textile products, as well as tea and other agricultural products. However, if the political situation deteriorates, the EU may consider suspending the agreement. Agriculture (tea, rubber, coconut), which depends on weather conditions, is expected to grow moderately. Political uncertainty is expected to undermine investor confidence, with the country already struggling to attract foreign investment. However, household consumption (62% of GDP in 2017) should benefit from the fact that inflation remains contained in the central bank's target range (4%-6%). The central bank is expected to continue to pursue a tighter monetary policy (key interest rate hike in November 2018) while increasing the level of liquidity in the economy (decrease in reserve requirements for banks).

Committed to a process of fiscal consolidation with support from the IMF, the Sri Lankan government took steps to achieve its target of a 1% primary surplus in 2018 with the entry into force of the Inland Revenue Act in April 2018, which simplifies the tax system and streamlines tax exemptions to increase revenue. Under the IMF agreement, the government projects a primary surplus of 2% in 2019. However, the political crisis could make it harder to achieve this objective: continued unrest could constrain reform implementation and affect tax revenues. In this context, the sustainability of public debt remains compromised, with USD 4.2 billion maturing in 2019. The conflict with Chinese creditors at the end of 2017 resulted in the cancellation of USD 1 billion of debt owed to China in exchange for granting the right to operate the port of Hambatoa. Borrowings in foreign currencies, which represent nearly 50% of public debt, are even more exposed due to the country's fragile external position. By mid-November 2018, the rupee had already lost more than 15% of its value since January, reflecting capital outflows related to increased political uncertainty. In 2019, the trade balance should be in the red again, with the services surplus remaining below the goods deficit despite the contraction in imports. A possible challenge to the trade agreement with the EU could further weaken the country's position. Expatriate remittances will not be enough to keep the current account in balance, and the deficit will not be offset by capital inflows, requiring new borrowing and the use of foreign exchange reserves.

Political crisis resumes in the run-up to the elections

The defeat of the governing coalition in the February 2018 local elections exacerbated tensions between the two parties, led by President Maithripala Sirisena (Freedom Party) and his Prime Minister, Ranil Wickremesinghe (United National Party), respectively. A political crisis was triggered when President Sirisena dismissed Prime Minister Wickremesinghe on October 26, 2018 without parliamentary approval. The appointment of Mahinda Rajapaksa (Sri Lankan Popular Front, winner of the February 2018 local elections) – who was President between 2005 and 2015 and is accused of war crimes against the Tamil minority in 2009 – added further fuel to the fire. Prime Minister Rajapaksa's new government has not won the confidence of Parliament, which is still largely loyal to Mr Wickremesinghe. The President’s attempts to dissolve parliament and hold early elections as early as January 2019 were declared unconstitutional by the Supreme Court, which also declared the Rajapaksa government illegitimate after two votes of no confidence in Parliament. Following these decisions, President Sirisena finally recalled Ranil Wickremesinghe as Prime Minister, but tensions between the two men remain extremely high. The situation will remain very unstable ahead of early 2020 elections, as Ranil Wickremesinghe’s party does not have a sufficient majority in parliament to implement the planned reforms (2/3 majority required). The political crisis will be a factor of tension in relations with Western countries, while providing a stage for the regional struggle for influence between India and China, which supports Rajapaksa. The risk of a resurgence in ethnic violence cannot be ruled out.